Although many healthcare executives expect that a physician practice acquisition will be a relatively easy deal to execute, they’re often surprised by the challenges encountered in getting practice acquisitions closed. We explore some of the common bumps in the road that can catch many experienced executives off guard when trying to execute physician practice deals for health systems.
Unachievable seller timing expectations
Many physician owners have no formal business training and have limited time to devote to the administrative and operational aspects of their practices. Most have never been involved in a transaction, and don’t understand the time and energy needed to successfully close a deal. It’s not uncommon for physician owners to be surprised by the amount of information that is requested by buyers as part of a normal due diligence/valuation assessment. Furthermore, they often expect that a deal will be finalized within a few months of the initial dialogue with the buyer.
Inferior financial and productivity information
The quality of the financial and operational data that many practices can provide is often inferior to deals involving larger target companies and can pose substantial challenges in the determination of normalized EBITDA for pricing the transaction. Many small to medium-sized practices only prepare cash-basis financial statements, so year-to-year comparisons can be skewed if the practice’s average collection rate varies or if any unique billing issues were encountered in a particular year. Many small practices have bare bones executive teams so billing issues can linger without getting adequate attention. It’s also not uncommon to have payments flowing to and from related entities, including real estate holding and billing companies. Since there may be common ownership between all entities, the owners often aren’t diligent about ensuring intercompany payments are at market rates or concerned if the entities miss payments in certain months. These issues can result in misleading financial statements that require substantial adjustments in order to get an accurate financial representation of the practice.
Unrealistic seller valuation expectations
Most independent physicians have heard stories about seven-figure purchase prices on past deals and have unrealistic expectations for a sale price. Most realize that each specialty has unique considerations that will influence pricing, but many don’t understand that there are substantial differences in how deals are structured depending on the buyer. As a general rule, health systems have historically chosen to offer a generous compensation model to physicians that usually maintains the physicians’ historical compensation or in some cases, increases it as long as the compensation doesn’t exceed fair market value (FMV). Furthermore, they historically have based a large portion of compensation on productivity with physician work RVUs being a common productivity metric. Since the selling physician will continue to receive compensation similar to or greater than historical compensation for similar production, there often isn’t any cash flow left in the practice after compensation. Accordingly, many health systems are reluctant to include a goodwill/intangible payment in their purchase price and may only consider the value of tangible assets. Many physicians don’t understand why they can’t maintain their compensation and also receive a seven-figure purchase price.
Private equity (PE) buyers have a different approach for physician practice acquisitions. They typically have focused their deals in certain specialties (dental, ophthalmology, gastroenterology, dermatology) and attempt to gain administrative efficiencies through scale. Oftentimes, they tie compensation to a percentage of collections versus work RVUs and may offer a compensation package that’s lower than the level historically earned by the physicians. Although the physicians may not initially like the lower compensation, the PE approach usually leaves cash flow (EBITDA) in the practice that can support a purchase price with a substantial goodwill/intangible payment. The PE buyers price the practice based on a multiple of the EBITDA that they expect will remain in the practice after compensation is paid, and common deal structures allow the selling physicians to maintain an equity position in the acquiring practice. They may also consider certain synergies that are expected if the acquisition is a tuck-in to an existing practice.
Hints to help reach the finish line
Communicate information needs and timing early in the process
Once a target practice is identified, it’s important to discuss the process, timing, and information needs with the physician owners so reasonable expectations are established. Buyers should have a clear plan regarding their contemplated process, including the preliminary financial review, valuation /compensation analysis, and formal due diligence. Since many health system buyers don’t have dedicated acquisition teams like PE buyers, they often rely on third-party assistance to determine an initial offer price and compensation package.
Selling physicians need to understand that substantial information will be needed and certain items may not be part of the practice’s normal financial reporting package. It may take several weeks just to compile the data and then more time to address the questions that will result after the buyer performs an initial review. They need to plan for additional demands on their administrative teams.
Determine if a quality of earnings analysis is needed
As early as possible in the process, the buyer should determine if a formal due diligence/quality of earnings (Q of E) analysis will be needed after (or possibly before) establishing a preliminary offer price. Although a Q of E analysis is standard for PE physician practice deals, many health system buyers only engage a valuation firm to assist with transactions. A valuation analysis will identify certain normalization adjustments to EBITDA but they typically don’t dive as deep as a formal Q of E analysis, which may include cash-to-accrual adjustments and a review of general ledger expense details not available in financial statements. Since that analysis often reveals additional EBITDA adjustments, health systems may want to consider it if they have any concerns about the adjusted financial statements that are the basis for their purchase price/compensation determination. The Q of E analysis can add time to the process and should be factored in the timeline communicated to the physicians.
Discuss approach for compensation
It’s important for the buyers to clearly communicate their philosophy for compensation to the selling physicians. There are a myriad of ways compensation can be structured and some flexibility with the level of compensation that can be offered without exceeding FMV. For the reasons discussed earlier, sellers need to understand that compensation and purchase prices move in opposite directions. If sellers want to maximize compensation, that will limit the purchase price that can be paid under the FMV standard. The more conservative compensation packages offered by PE buyers are what allows them to support richer purchase prices. The selling physicians can’t have their cake and eat it too.
Know when to pull the plug
The acquisition process requires substantial time and energy for both buyers and sellers. There is always room for negotiation in any deal but the compliance considerations in healthcare may limit the flexibility of certain buyers more so than other industries. If you reach an impasse with the sellers, you may need to walk away.
